Thursday, October 26, 2006

Alternatives to the Pigou Club

Today’s Wall Street Journal prints various letters in response to my oped on gas taxes. Rather than responding to to the specific points, or to all the comments posted on this blog, let me try to spell out more generally the alternatives from which we must choose.

Members of the Pigou Club favor higher Pigovian taxes in order to remedy externalities such as pollution and congestion while raising government revenue. If you aren’t a member of the Pigou Club, you most likely fit into one of these four categories.

1. You deny the existence of these externalities as a type of market failure. Perhaps you think you live in a Coasian fantasy world where people bargain without transaction costs to reach efficient allocations. (Note: I am not suggesting that Coase himself thought we lived in such a world—he considered it only a useful thought experiment.)

2. You recognize the externalities but you don’t think the government should try to respond to them. You are such a believer in small government that you are willing to live with inferior economic outcomes, such as pollution and congestion.

3. You recognize the externalities, think the government should try to correct them, but think the current low taxes we put on gasoline are sufficient. In this case, you have weighed and rejected the evidence, such as that of Parry and Small, that higher Pigovian would be optimal. (Parry and Small calculate an optimal tax of $1.01 for the United States in today's dollars. After my proposed phase-in of a $1 hike, the U.S. tax would be $1.40. Assuming 10 years of 3 percent inflation, the tax in real terms would approach almost exactly what Parry and Small recommend. By the way, the published version of Parry and Small was in the American Economic Review, September 2005.)

4. You recognize the externalities but think the government should try to correct the market failure through regulations (such as CAFE standards) or through market-based solutions that do not raise government revenue (such as cap-and-trade systems). Perhaps you are concerned that government would waste the extra revenue on useless government programs.

Let me respond to group 4, because my guess is that this is the largest group of antipigovians.

The reason I am less concerned that the extra revenue will be spent is that it already has been spent. The federal government has promised benefits to the elderly far in excess of what it can pay. At some point the nation will have to reckon with the looming fiscal gap. The most likely political compromise will involve higher tax revenue. We should, therefore, be ready to increase revenue in a way that does the least damage—or, better yet, the most good. If not Pigovian taxes, then other taxes will be increased.

An optimistic libertarian might hope that we can deal with the looming fiscal gap without raising the ratio of taxes to GDP above its current level. I wish I could believe that this were possible. In a previous oped, I advocated increasing, slowly but substantially, the age of eligibility for Social Security and Medicare. But even if we could scale back government spending in such a radical way, Pigovian taxes would not lose their appeal. Let’s use the extra revenue from Pigovian taxes to reduce distortionary taxes, such as income taxes. Politically unrealistic, you say? Surely, if a future government were so libertarian as to manage a radical reduction in entitlement promises to the elderly, it would have no trouble delivering equally radical cuts in income taxes. In fact, the tax cuts would be the easy part of the package.

Update: Some comments suggested new categories of nonpigovians, and some suggested the categories I described were strawmen. To be clear, my goal was to categorize, as logically as possible, the various points of view. Let me try to put the issue in terms of a flow chart.

Question: Do you believe consumption of gasoline is free of negative externalities leading to market inefficiency?

If YES, you are part of group 1.If NO, continue.

Question: Do you believe that public policy should ignore these externalities?

If YES, you are part of group 2.If NO, continue.

Question: Do you believe the current tax on gasoline sufficiently internalizes the negative externalities?

If YES, you are part of group 3.If NO, continue.

Question: Do you believe the best remedy for the remaining externalities is a regulatory system rather than a higher tax?

If YES, you are part of group 4.If NO, you are a member of the Pigou Club.

About Me

I am the Robert M. Beren Professor of Economics at Harvard University, where I teach introductory economics (ec 10). I use this blog to keep in touch with my current and former students. Teachers and students at other schools, as well as others interested in economic issues, are welcome to use this resource.